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Chapter 2
Chapter 2
True/False
Easy:
(26.1) Taxes and capital structure FQ Answer: a EASY
i. In a world with no taxes, MM show that a firm’s capital structure does not
affect the firm’s value. However, when taxes are considered, MM show a
positive relationship between debt and value, i.e., its value rises as its
debt is increased.
a. True
ii. According to MM, in a world without taxes the optimal capital structure for a
firm is approximately 100% debt financing.
b. False
iv. MM showed that in a world without taxes, a firm’s value is not affected by
its capital structure.
a. True
v. The Miller model begins with the MM model with taxes and then adds personal
taxes.
a. True
vi. The Miller model begins with the MM model without corporate taxes and then
adds personal taxes.
b. False
vii. Other things held constant, an increase in financial leverage will increase a
firm's market (or systematic) risk as measured by its beta coefficient.
a. True
Medium:
(26.2) MM models FQ Answer: a MEDIUM
viii. The MM model with corporate taxes is the same as the Miller model, but with
zero personal taxes.
a. True
ix. The MM model is the same as the Miller model, but with zero corporate taxes.
b. False
xi. In the MM extension with growth, the appropriate discount rate for the tax
shield is the WACC.
b. False
xii. In the MM extension with growth, the appropriate discount rate for the tax
shield is the after-tax cost of debt.
b. False
xiv. When a firm has risky debt, its debt can be viewed as an option on the total
value of the firm with an exercise price equal to the face value of the
equity.
b. False
xviii. Which of the following statements concerning the MM extension with growth
is NOT CORRECT?
a. The tax shields should be discounted at the cost of debt.
xix. Which of the following statements concerning the MM extension with growth is
NOT CORRECT?
e. The total value of the firm is independent of the amount of debt it uses.
xxii. Your firm has debt worth $200,000, with a yield of 9%, and equity worth
$300,000. It is growing at a 5% rate, and its tax rate is 40%. A similar
firm with no debt has a cost of equity of 12%. Under the MM extension with
growth, what is the value of your firm’s tax shield, i.e., how much value
does the use of debt add?
b. $102,857
Multi-part:
(The following data apply to Problems 23 through 25. The problems MUST be kept together.)
The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and
a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of
equity to an unlevered firm in the same risk class is 16.0%.
(The following data apply to Problems 26 through 28. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax
rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in
net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar
company with no debt has a cost of equity of 11%.
Trumbull, Inc., has total value (debt plus equity) of $500 million and $200
million face value of 1-year zero coupon debt. The volatility () of Trumbull’s
total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and
N(d2) = 0.9050.
xxx. What is the value (in millions) of Trumbull’s debt if its equity is viewed
as an option?
b. $186.19
Firm L has a total value of $200,000 + $300,000 = $500,000. A similar firm with no debt should have a smaller value. Here
is the calculation:
VTotal = VU + VTS, so VU = VTotal – VTS = D + S – VTS.
Value tax shelter = VTS = rdTD/(rsU – g) = 0.09(0.40)($200,000)/(0.12 – 0.05) = $102,857
VU = $300,000 + $200,000 – $102,857 = $397,143
VTotal = VU + VTS
Value tax shelter = VTS = rdTD/(rsU – g)
VTS = rdTD/(rsU – g) = 0.09(0.40)($200,000)/(0.12 – 0.05) = $102,857
First, note that the leveraged value of the firm is $587,500 as found in Problem 23. Note also that the firm has $500,000 of
debt. Therefore, the value of its equity must be $87,500. Using these data, we find the leveraged cost of equity as follows:
VU = FCF/(rsU – g)
= $80,000/(0.11 – 0.06)
= $1,600,000
xxviii.(26.4) MM extension with growth CQ
Answer: a MEDIUM